A wall of money is coming toward the Australian super industry and expected mergers are right behind. Like it or not, we are headed for massive scale. But where does this road take us? Should we expect better returns and/or lower fees for super fund members? Is this going to transform this industry into something akin to a ‘big 4’ super funds, with a different (and more corporate) culture, mass marketing and distribution, and big executive pay-packets? Can we manage this change somewhat, or should we ‘strap in’?
There are great seductions of scale that tell stories of an industry flush with Australian talent, expertise, and a beacon of intellectual thought leadership, the envy of international asset owners and sovereign wealth funds. In the meantime, the super industry faces the enviable challenge of where to put a lot of new capital, and the challenges and pitfalls that the promise of scale brings, both for the members it servers, but also for the industry, and the employees of these funds.
Investment management involves building and governance of complicated technical machinery. It is essentially an intellectual exercise in shaping delicate forecasts of the future, aligning these across human capabilities and placing them gently in the cradle of a portfolio. Scaling investment expertise faces a number of headwinds, but three appear to be of primary importance: complexity, people, and liquidity.
With bigger budgets, bigger assets under management, and more voices in the conversation, there are naturally new ideas to explore, especially when driven by competitive forces to continually improve and ‘win’. The pursuit of new methodologies, technologies such as AI and data science for example, require firms to create new divisions within their own borders, staff and resource them, and set about delivering outcomes. Importantly, the diversity of activities, conversations, teams, and specialisations can be a challenge to govern, align, and ultimately scale.
Diversity is a closer neighbour of diversification in finance,and so having more teams doing more specialist work could be better for portfolio outcomes, but it certainly doesn’t improve economies of scale. The ability to prune back ambition and to forcibly slow down the breadth of change, must push against an insatiable desire to be across all opportunities in the market.
The second barrier to achieving scale is from sheer increase in the quantity of people, and the complexity that it brings. A typical asset management firm will have teams working on the investment process, investment models, research and development, investment decision trees, trade execution, portfolio monitoring, market and operational risk management, transparency, audibility, reporting, marketing, communication, and so on. And that’s just the investment side. Staffing these large teams with qualified, motivated and engaged people is a challenge, never mind training, managing and retaining them.
As teams grow, the cost of constant communication and coordination starts to impact daily life. Coffee conversations turn into late night marathon teleconferencing calls, and silos emerge as ‘information overload’ drives most people into professional hermits. For the communities of people working in this industry, this may well conjure understandable nostalgia for simpler days, and will naturally drive many out.
More managers with more money
Compensation is also on the table. Larger funds can afford to pay greater compensation for senior executives and attract global talent. According to Investment Magazine’s survey in 2018, the average CEO (CIO) in the top 50 had a total compensation of $478,000 ($500,000). The average fund size surveyed was 20 billion in AuM, though it was highly skewed. Even so, the correlation between size and compensation was strong (0.75). A regression showed me that the average salary for CEO (CIOs) was higher by $5,000 ($8,000) for every $1 billion under management (or 1 per cent of the average compensation) compared to smaller peers.
Not only does it pay to manage a bigger fund, but it also pays more if that fund grows at the same returns as a smaller fund. This means that for a $100 billion fund, a return of 10 per cent (which also results in higher AuM of $10 billion) should also reflect in a 10 per cent increase in compensation change for its senior managers, whereas the same return for a $10 billion fund (or $1 billion), would only generate 1 per cent increase in compensation.
The evidence on the benefits of scale is not encouraging so far. A 2018 report by the Productivity Commission showed that “pass-through of economies of scale (through lower average fees) is not evident on casual inspection of the data.” The authors estimated benefits from economies of scale (specifically up to $30 billion) as significant, but benefits have not historically been passed onto members in the form of lower fees. You could argue that the auxiliary services, such as member education, may have been the beneficiaries.
Liquidity is always a constraint to investment processes, especially those that operate in smaller markets, and those that take advantage of small cap mispricings. Strategies have a natural capacity, after which the marginal alpha they can generate diminishes. Adding more strategies in public markets moves funds toward using scalable, cheap, semi-passive and passive strategies, which are cost effective and provide the same exposures.
More complex hedge funds face similar outcomes. When manager skill is costly and hard to identify, larger allocations have opted for fewer, more scalable, big global managers that can provide expertise and advise in other areas of the investment process. Typically, these are smart-beta, and quantitative techniques that use scalable data and algorithms to target predictable return patterns. The move toward this segment of the market is not necessarily ‘better’, but it is more scalable.
Do opportunities come in all shapes and sizes?
Opportunity size is often used to argue for scale. The expertise and capital required to participate in offerings of certain projects necessitate the presence of large, sophisticated investment teams with a lot of capital. With direct investments, there is no opportunity to buy a part of a fund, and the minimum participation size is prohibitive for small entrants. This may mean better opportunities, but it almost certainly means more capital flowing overseas as well, essentially bypassing smaller but more locally meaningful investment opportunities in Australia.
Micro-finance, and scalable technology to provide lending, and private debt has made smaller capital needs much more accessible for large institutional investors, from algorithmic retail housing investments to small business lending, the notion that large tickets are prohibitive is likely to be much less of a barrier in the future.
The decision is academic in some sense: the tidal wave of capital and mergers are here, and more to come. Boards, senior executives and regulators are paying close attention as this industry shifts to being much more powerful, much broader, and embracing the tricky promises of scale, technology and a new world.
Michael Kollo is a former general manager of quantitative solutions and risk at HESTA
Great article, particularly the point around strategies having a natural capacity. The demand to invest more and more money has to have a result of averaging out returns.